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LONDON (Reuters – Investors take out Credit Default Swaps (CDS), to cover the risk of a Russian sovereign default.

We will show you how CDS works and explain why Russia’s situation is more difficult than it should be.

WHAT IS CREDIT DEFAULT SWAPS?

CDS can be compared to insurance contracts, offering protection from specific risks.

These are usually purchased to provide protection from default of a particular bond, but they also have flexibility and can be tailored to address different situations, timesframes, countries, banks or even multiple companies.

How do you buy a CDS?

As investors look to protect their investment risk, many big international banks sell CDS. Risk of not receiving paid back determines the cost.

HOW DO THESE INSURANCE POLICIES PAY-OUT?

The process starts with a market participant, usually an investor who has bought a CDS, asking a group known as the Credit Derivatives Determinations Committee https://www.cdsdeterminationscommittees.org/about-dc-committees(DC), to look at whether a default or ‘credit event’ has happened.

There are five DCs https://www.cdsdeterminationscommittees.org/about-dc-committees/current-dc-membersdc-members-april-2021-to-april-2022/#EMEA for different parts of the world. They can have up to 15 voting members https://www.cdsdeterminationscommittees.org/about-dc-committees/current-dc-membersdc-members-april-2021-to-april-2022/#EMEA made up mainly of the big banks and investment funds that use or sell CDS such as Goldman Sachs (NYSE:), JPMorgan (NYSE:), Bank of America (NYSE:), PIMCO and Citadel.

The DC’s role is to “factually, evidence-based determine” what constitutes default.

Non-payment can occur in five situations. There are five common scenarios where non-payment can occur: bankruptcy, failure, restructuring of debt, an obligation acceleration, default on another bond, repudiation, or moratorium.

WHAT HAPPENS THEN

The CDS contract must pay out if a nonpayment event is determined. Investors have the right to surrender their bonds to the CDS seller to receive 100 percent of the bond’s “par” value.

If the investor doesn’t have the bonds they are looking for, then the buyer must buy them from another person who does. The CDS bond auction facilitates this process. Participants look at the bonds markets and attempt to figure out the worth of the defaulted assets.

If it is difficult, a cash settlement can be used instead of a physical settlement. 

WHY IS THIS SITUATION COMPLICATED

This key step of the settlement process could pose a problem.

Sixteen of Russia’s euro or 15 dollar international market bonds are legal. This allows the government in Russia to make bond payments in Russian roubles, if the Russian Federation is not able to pay principal and interest in U.S. dollars.

Moscow using this “fallback” option will cause problems as it’s not possible to convert the roubles into dollars and euros. Additional sanctions would ban Russian bond trading and make it difficult for bondholders not to hand over their defaulted bonds. CDS sellers may argue that they don’t need to be paid.

WHEN WILL RUSSIA DEFAULT, AND KICK ALL OF THIS PROCESS OFF.

Russia’s next hard currency bond payment is two regular interest payments, or a ‘coupon’. They are due March 16th. The grace period is also known as a 30-day grace period. A default would be formally declared on April 15.

But, CDS determinations has already been asked to consider what can happen to those bonds with the Rouble Fallback Option.

HOW MUCH MONEY IS AVAILABLE?

JPMorgan, an investment bank estimates that there are approximately $6 billion in outstanding CDS to be paid out.

Investors that purchased insurance for Russian bonds are likely to save a lot of money. Because the default risk was considered low prior to the crisis, CDS were inexpensive.

(Graphics: How a CDS works: https://fingfx.thomsonreuters.com/gfx/mkt/mopandonjva/Pasted%20image%201646762396341.png)

(This story refiles in order to remove an extraneous term from its headline.